It has been almost two decades since Orange County – among the richest anywhere anytime – declared bankruptcy as a consequence of exotic trades using supposedly risk-free mortgage and other government backed securities. Less well remembered is that the San Diego County pension fund did the same thing, losing hundreds of millions of dollars but avoiding bankruptcy. We are reminded of this incident by Dan McSwain, who reports the county is now employing a very similar strategy currently using leveraged investments in Treasury bonds.

The basic problem is that the pension fund reserves are based on the politically inspired target return of about 8%, pensions are adjusted for inflation and taxpayers back up this assumption by making up earnings shortfalls. As I wrote in a letter published by the U-T about eight years ago, the more appropriate assumption would have been about half that - later confirmed by studies at Stanford and Northwestern universities in 2010 – which I concluded implied that the City of San Diego was technically insolvent, and probably the county as well.

Losses during the 2008 crash offset much of the previously high earnings and ever since Chairman Bernanke’s zero interest rate policy has widened the gap while temporarily inflating stock and bond prices. Almost all state and local pension funds face this gap, and most are trying to employ “go for broke” strategies to close it by investing in hedge funds that employ such exotic strategies. As reported in Hedge Fund Miracle in 2012, the weighted average cumulative annual net of fees hedge fund return since inception in the 1970’s is zero – not that surprising when you consider that each fund is trying to outguess all the others and lots of “dumb” money follows the smart money- implying that the vast majority of funds relying extensively on these strategies to close the gap will go broke.

How to get from the risk-free rate of about 0% to the assumed rate of about 8%? As Maine's down easters would say: "you can't get thar from har."